An employee stock option is the right of the employee to buy a specified number of shares in the employer corporation at a specified price (the strike price, grant price or exercise price) at a specified time in the future not earlier than the maturity date and not later than the expiration date. The option will not usually vest for a number of years after the grant and to encourage the employee to stay with the company. Portions of the options may vest in stages (flights). Usually the maturity date is the same as the vesting date. Most options lapse after a certain number of years from the grant date. The employer may set the exercise price at the market value at the time the option is granted (at the money) or below market value (in the money). If the stock appreciates the employee can acquire stock at below market value and realize a gain when he or she sells the stock.

Community Property in Stock Options

In California the courts have held that the community has an interest in stock options granted during the marriage and exercisable after the date of separation to the extent their grant is attributable to community efforts during the marriage. In determining whether stock options are deferred compensation for past community efforts, compensation for present efforts or incentives for future services and retention, the court has extremely broad discretion to select an equitable method for allocating the community and separate property interest. FN1. Cases have held that stock options granted and exercisable during marriage are wholly community and those granted after the date of separation are separate property. FN 2.

In cases where the stock options were granted during marriage but do not vest or become exercisable until after the date of separation, the Courts have developed the following time rules to determine the marital interest. However, these are not rigid rules and the Courts have indicated that they are willing to apply any formula that is equitable in the circumstances.

A. In Re Marriage of Hug (1984) 154 Cal. App. 3d 780, 782.

Months between start of employment and date of separationMonths between start of employment and date when options first exercisable

x number of shares which can be purchased when the option is first exercisable

The court was influenced by a number of factors: employee induced to join company by promise of stock options; employee anticipated that he would be granted options when he joined the company; employee granted stock options in lieu of other compensation during initial start up period; nothing in plan indicated that were solely for future services.

B. In Re Marriage of Nelson (1986) Cal App. 3d 150.

Months between date of grant and date of separationMonths between date of grant and date when options first exercisable

X number of shares which can be purchased when the option is first exercisable

The court distinguished Hug and focused on the date of grant since the options were granted to secure future performance evidenced by the fact that grant price was the fair market value at the date of grant (at the money) and for the employee had to stay on at the company while the market value of the shares increased in order to make a profit. The court also held the trial court did not abuse its discretion when it credited the employee with his estimated tax liability for future gains in spite of the rule that liabilities that are not “immediate and specific” should be disregarded.

Months between date of grant and date of separationMonths between date of grant and date that the stock fully vested and not subject to disinvestment

X gain on the stock option on the date of exercise (after cost of purchasing option and taxes paid on gain).

In Harrison, the stock options did not unconditionally vest until after the date of separation and were therefore deemed primarily an incentive for future services. Walker held that it was an abuse of discretion for the Court to apply the Hug formula and to disregard the date when the stock vested.

The Walker court also explained in calculating the community interest the “time rule” fraction could be multiplied any of the following:

1. If at the time of trial the option has been exercised and the stock sold, the difference between the option price and the sales price.2. If the option has been exercised but the stock has not been sold the court has the discretion to either order the stock divided in accordance with the community interest or order the employee spouse to buy out the other’s community interest which would be the difference between the value of the stock on the date of trial and the option price.3. Determine the community interest in the unexercised options and order the employee to deliver up to one half of the community interest share. Each of these solutions presents problems. If the options are not yet exercisable valuation is difficult and may require an expert to use a valuation model e.g. Black/Scholes pricing model. Also stock options are rarely assignable due to company restrictions and potential adverse tax consequences. Therefore, a preferable alternative is to negotiate a deferred distribution approach where the employee spouse retains the options but the other spouse shares the after tax gain when the options are exercised and the shares are sold. Any such negotiated settlement should contain notification provisions if the options are reloaded or repriced or exercised, provisions that confer on the non-employee spouse the right to direct the employee spouse to exercise options on his or her behalf, and how taxes will be calculated.

In determining the correct “time rule” formula some factors to consider in assessing whether the options are for past, present or future performance are:

Review the option plan terms and any documentation relating to the grant

Options for a specific purpose or a bonus (past performance)

A reward for long term employment or under compensation in the past (past performance)

Part of a compensation package (present performance)

A form of signing bonus for a new employee (present performance)

In lieu of current compensation or in addition to salary especially where options are granted on a regular basis and the company is a start up (present performance)